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Two European elections, one feared outcome

February 22, 2013: 5:00 AM ET

All eyes this weekend will be on one large economy in Europe, Italy, and one small one, Cyprus. Elections there could send the markets back into a frenzied state of uncertainty over the euro's future.

By Cyrus Sanati

italy-economy

FORTUNE -- The outcome of two elections this coming weekend could push Europe back to the edge of economic calamity. Sovereign bond investors in London and on the continent will be watching voter returns in Italy and Cyprus intently to see if anti-bailout and anti-austerity candidates triumph at the polls. If the results lead to radical or deadlocked governments in either nation, the markets could punish government bonds throughout the eurozone periphery, reigniting investors' fears of a potential collapse of the euro.

It has been some months since the eurozone debt crisis dominated world headlines. Steps taken by the European Central Bank, along with promises of reform from member nations helped to calm the jittery bond market, thus ameliorating the crisis.

Unfortunately, European leaders have since squandered the breathing room that investors gave them to deal with the root causes of the crisis. The formation of a banking union seems far off, and the chance that we could see a truly united Europe with a common fiscal policy appears now to be a flight of fancy. Despite these disappointing results, investors have pretty much given the continent a pass as it appeared that the most troubled nations in the Eurozone were containing their fiscal largess and were taking concrete steps to stabilize their uncompetitive economies.

But this détente between the markets and Europe might come to a close this weekend as voters in Italy and Cyprus head to the polls. In Cyprus, there is a runoff between two very different candidates -- one who is in favor of accepting a bailout agreement to save its crippled banking system and one who who remains hesitant. In Italy, the market's favorite to win, Mario Monti, is doing very badly in the polls, while the market's least favorite candidate, the notorious Silvio Berlusconi, could be on course to take back power after having it yanked from him in 2011.

Cyprus

The island nation on the eurozone's extreme periphery has been shut out of the international financial markets for nearly two years thanks to a banking crisis that has frozen its economy. Cypriot banks invested heavily in Greek sovereign debt, thinking that its sister-nation's bonds were as good as gold. They weren't, and when the EU forced Greek debt holders to take a massive haircut on their holdings, Cypriot banks got the shaft, locking up lending in the nation.

Cyprus is seen by many EU politicians as too small to help (or to care about), but investors fear that its collapse could light up an already tense situation for the euro. The country needs a 17 billion euro or nearly $23 billion bailout from the European Union to secure its banks and avoid missing a 1.4 billion euro debt payment due in June. That may not seem like a lot of money, but it is roughly equivalent to Cyprus' entire GDP, so it is quite a large number for them.

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Last weekend, Cypriots went to the polls in a first-round contest to elect a new government. The bailout figured heavily in the election with candidates campaigning on either being for or against accepting aid from the EU and International Monetary Fund. Thankfully for investors, the first round eliminated the independent candidate Giorgos Lallikas, who came in a close third in the voting with 25% of the vote.

The center-right Democratic Rally (Disy) candidate, Nicos Anastasiades, who was for the bailout, garnered 45% of the vote, making him the big winner. He will face off against the Communist party candidate, Stavros Malas, who received 26% of the vote. Malas is not as radical as Lallikas, but he does object to several preconditions that will surely be required for any bailout, most notably, the selling off of state-owned companies.

If Malas pulls out an upset in Sunday's election, the markets could go haywire on Monday as investors scramble to adjust their positions. But Cyprus is still super small. Its failure would not sink the euro; rather, it would create instability which could cause investors to turn bearish on European sovereign debt as a whole. Given how faith-based currency is these days, especially with so many governments running the printing press, instability could be all that is needed to send the euro back on a downward spiral.

silvio-berlusconi

Silvio Berlusconi.

Italy

In contrast, if a nation as large as Italy were to fail on its commitments, the euro would be in immediate grave danger. That's why investors this weekend will also be eyeing the returns flowing in from parliamentary elections in Italy -- the first since the euro crisis began in 2009. Italy has had a change in government during that time, though, when in 2011 then-premier Silvio Berlusconi agreed to step down and turn over the reins of power to an unelected technocrat, Mario Monti.

In reality, Berlusconi was basically thrown out of office by investors, who had started to require unsustainably high interest rates to hold Italian debt. Years of financial mismanagement and fiscal short-sightedness on the part of the Italian government, which had been run on and off by Berlusconi and his conservative coalition for the past two decades, had finally started to bite. Italy, with its debt-to-GDP ratio of 120%, bloated public sector, and flat economic growth rate was like a ticking financial time bomb. and no one wanted to be near it when it blew.

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In the past year Monti has instituted a number of reforms to get Italy back on solid fiscal ground. He has cut services, reformed the nation's generous pension system, raised sales taxes, and introduced a new tax on private property. Italian bond yields fell as investors became more comfortable with Monti and saw that he was serious in achieving real reform.

Now, barely a year out of power, Berlusconi wants back in, running for his old job with the support of Italy's conservative coalition. He is campaigning on a promise to grow Italy's economy by reversing many of the unpopular, yet necessary, measures taken by Monti in the past year to help stabilize Italy's precarious fiscal situation.

Monti, who had previously said he would not seek reelection, has been pressured to run as an independent candidate in an effort to thwart Berlusconi's ambitions. The two men are joined by Pier Luigi Bersani, the head of the leftist coalition in the Italian parliament. Whichever man's coalition wins a plurality of the votes in the lower house and a plurality of votes in each of Italy's 20 regions in the upper house will secure the votes needed to take the reins of power.

Monti isn't expected to do very well in the election as he doesn't have the backing of the two dominant political factions in the country, but he could play the role of "kingmaker" by helping whoever comes into power secure a majority in the upper house of Parliament. Monti, of course, is more apt to support Bersani over Berlusconi in this case, but stranger things have happened.

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The last opinion poll released shows Bersani in the lead with 34% of the vote, Berlusconi with 28% and Monti with 13%. Since Italian election law bans the publication of polls two weeks in advance of an upcoming election, it is unclear what the pulse of the nation is at this point. Berlusconi claimed in a rally earlier this week that he has surpassed Bersani since the last poll was taken. It is not out of the realm of possibility, seeing that an estimated 20% to 27% of Italians have yet to make up their minds as to who they are voting for. A Berlusconi-led government should therefore not be counted out.

That would send the wrong signal to the markets. Indeed, any government that doesn't involve some sort of meaningful presence by Monti would be seen as a negative for Italy. As Berlusconi's popularity has gained in the polls, Italy's financial markets have moved into negative territory. The FTSE MIB Index, a listing of Italy's 40 largest publicly-traded stocks, is down 8% this month, while yields on Italian bonds have moved up from 4.13% to 4.40%.

But Italy's problems go beyond just Berlusconi. It is hard to see how any coalition could muster enough political capital to make the necessary changes to Italy's broken economic engine. The nation has had no economic growth since it entered the euro in 1999 and has had to borrow billions of euros to keep the nation afloat. During the same time productivity dropped while labor costs shot up precipitously. These are all very serious structural problems that require a strong leader.

The eurozone crisis never ended, it just went on holiday for a bit. While the ECB has pledged to support the euro by any means necessary, its solution, simply printing and throwing money at the problem, isn't going to cut it over the long term. Sovereign bond traders know this all too well, but they are playing along -- for now. But it is unclear what will cause them to make a dash for the exits. It could be something big, like an Italian sovereign default or something small, like a banking crisis in Cyprus. This weekend's elections should therefore give us a peek as to how much time is left on this ticking financial time bomb.

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